NSR H1 2018 (8) – Currency: NGN Cautiously Constructive for 2018

Acknowledging
the downtrend in Nigeria’s imports and lower incentives for round tripping in
the FX market, we believe the decline in autonomous flows will pressure the
apex bank to bridge the short-term demand-supply overlap over 2018. Imputing
our inflation and interest rates forecasts on the PPP model, we see fundamental
driven pressures underpinning the scope for down-leg in the USDNGN (8-10% from
current levels) over 2018 – which implies average exchange rate of N401.55/$ to
N403.54/$ over 2018.CBN slows its tap as Hot money fires upOver
the second half, FX flows were more significant than anticipated in our H2 17
Nigerian Strategy Report. Basically, we had projected a moderate decline in
monthly dollar sales by the CBN, from average of $2.9 billion in May/June to
$2.0 billion in the review period, underpinned by a reduction in pent-up
demand. Much of the cutback was expected to emanate from the special
intervention forward contracts which contributed 38% of CBN’s monthly dollar
sales in the first half of 2017.To
add, we firmed up our upbeat outlook on portfolio flows which should combine
with CBN sales to leave the IEW relatively greased with dollar supply.
Consequently, our postulation implied a $2.5 billion decline iFX reserves to
$27.8 billion by year end (H1 17: $30.3 billion).The
variance in our expectation compared with actual figures emanated from a
combination of robust portfolio inflows and higher oil receipts. For context,
CBN average monthly
dollar sales over Q3 17 declined by 14% to $2.1 billion relative to $2.5
billion in Q2 17 with September sales printing at $1.5 billion. Notwithstanding
the cutback in dollar sales, which largely reflected lower sales at the
interbank and parallel market, the naira remained stable over Q3 largely due to
higher than expected portfolio flows over the period (average Q3: $1.4 billion,
H1 17: $470 million).Against
this backdrop, the CBN reduced its supply at the IEW from $845 million in June
2017 to $101 million in September 2017 while also intervening in other segments
of the market, particularly the Secondary Market Intervention Sales (SMIS).
Furthermore, despite strong (but moderating) dollar sales by the apex bank,
external reserves firmed up by 28% over H2 17 to $39 billion on the back of
higher oil inflows. Consequently, the premium between the parallel and official
market contracted to a 27-month low of 17.0% at the end of December - the naira
also gained grounds over the period at the NAFEX and BDC segment, appreciating
by 2.8% and 2.3% respectively.

Interbank garners support from fundamentals and carry
flowsTracking
the performance in H1 17, sturdy accretion to reserves (+718% QoQ to ~$2.8
billion) improved Nigeria’s financial account, with the widening CA surplus
further tapering concerns over naira resilience in H2 17. Notwithstanding the
decline in CBN sales by 81% QoQ to $688 million in Q3 17 (Q2 17: $3.6 billion)
at the NAFEX end, the naira appreciated further (+3.7% QoQ to mean of
N362.92/$) with daily average marketturnover
rising 101% QoQ to $157 million. The strength of the naira amidst sturdyturnover during the period, is not unconnected
with the regulatory move to fast-track thesynchronization
of FX rates in Nigeria.In
July, the FMDQ selected Bloomberg as a partnersaddled
with the responsibility to report transactions in the IEW electronically and
enhanceprice discovery and transparency.
Consequently, Bloomberg’s USDNGN reportingbecame
based on the IEW as opposed to the CBN-determined Wholesale SecondaryMarket Intervention Sales (SMIS) interbank rate.
Furthermore, in August, the apex bankdirected
banks to quote the floating IEW rate rather than a fixed exchange rate, a moveperceived as moving towards a unified, floating
exchange rate.In
Q4 17, the sustained ascent in FX turnover (+29% QoQ to $204 million) reflected
improved confidence and transparency on the back of the regulatory move at
unifying the exchange rates at various ends of the market. Consequently, the
naira extended gains at the NAFEX closing at N360.31/$ (+0.8% QoQ) in Q4 while
the parallel rates and BDC also appreciated (+1.22% and 0.8% respectively). In
our view, the lower intervention by the apex bank in the IEW provided scope for
increased dollar sales in the BDC and SMIS.

NGN optimism: Unfaltering or a damp squib?Against
the backdrop of general improvement in the external sector, one could argue
that the naira stability looks set for a sweet sail over 2018. However, despite
improving fundamentals, we anticipate greater uncertainty in H2 2018 as
politicking enters full gear.In
framing our currency outlook, we examine developments in the BoP with more
emphasis on the fundamental picture. Starting with the exports, we expect the
higher crude offtake to persist especially over H1 18 stemming from higher
crude oil prices and production.Assuming
mean crude price of $60/bbl. and oil production of 2.0mbpd in 2018, we project
a 10% YoY increase in goods exports to $47.3 billion. On imports, we estimate a
15% YoY growth to $37.3 billion, as we expect sustained FX liquidity to
encourage increased importation of manufacturing products, with sustained
reduction in the importation of petroleum products and raw materials should
moderate the impact.Overlaying
the implied goods trade surplus of $10.2 billion with service and income
deficit on our target net current transfers, we estimate the current account to
print at $6.3 billion (FY 17E: $8.1 billion). On the financial account, we
expect a combination of the gradual unwinding of QE in developed economies –
especially rising US interest rates – and bullish economic picture in developed
economies to induce net FPI outflows from emerging markets. As a result, we expect
a further drawdown in FX reserve as the apex bank intervenes to bridge the
lower FPI flows. On balance, we expect the financial account to print at a
lower level relative to prior year.Having
resolved the BoP considerations, we then look to evaluate the potential
liquidity picture across the FX markets. While we note the resilience of
capital flows into Nigeria from the flexible exchange rate system, which buoyed
demand for naira-denominated assets over H2 17, we believe the political
related risks ahead of the 2019 election and our expectation of a lower yield
environment over 2018 will moderate inflows.Acknowledging
the ripple effect of turnover in the IEW on overall naira stability over H2 17,
we expect a decline in FPI flows to weigh on overall autonomous flows and drive
increased demand for CBN intervention at the window.

Adjusting
current net reserve levels of $38.77 billion (excluding outstanding swap
liabilities of $2 billion), with CBN having access to only 73% of total
reserves, we estimate that import cover, using net reserves, should remain
above 10 months by the end of H1 18. However, we expect a steeper drawdown in
FX reserves over H2 18 as the political concerns – with electioneering
activities expected to enter its prime – further dampens flows into the
economy, with current flows taking a safe flight. While noting the healthy
reserves at the disposal of the apex bank, our expectation for a decline in
portfolio flows, speaks to moreaggressive
sales by the apex bank (even a stronger participation by the apex bank in theIEW) to keep the dollar within current band.Overlaying
the steep decline from May, whendollar
sales was at a peak of $3.4 billion – to $1.5 billion in September on our
monthly salesover 2018, we estimate a
monthly sale of $2.0 billion (with overall average monthly outflowfrom the CBN estimated at $3.6 billion) stemming
from the increased intervention at theIEW,
with the cut back on special intervention forward contracts creating some
cushion.

Acknowledging
the lower incentives for round tripping in the FX market (with the narrowing
gap between the Parallel-NAFEX and BDC-Interbank), we believe the decline in
autonomous flows will pressure the apex bank to bridge the short-term
demand-supply overlap over 2018. Imputing our inflation and interest rates
forecasts on the PPP model, we see fundamental driven pressures as underpinning
the scope for down-leg in the USDNGN (8-10% from current levels) over 2018 –
which implies average exchange rate of N401.55/$ to N403.54/$ over 2018.Is the Naira running ahead of valuation?At
the heart of the debate behind contraction in market premiums and stability at
the NAFEX window, is that the NGN appreciation will be short-lived and
near-term fundamentals
suggest a possible weakness. To ascertain the extent of undervaluation or
otherwise, we examine quarterly REER data from the IMF on the NGN over the last
three decades to apply the Purchasing Power Parity (PPP) concept which holds
that currencies gravitate towards their long run mean over time.Looking
at the data, recent NGN appreciation has driven the REER above its long run
average (defined as the average over the period of the data). Extrapolating
into equilibrium REER, the NGN REER deviates by a narrow range from its
equilibrium values, potentially providing the likelihood of a downtrend to
retrace its long run equilibrium, with the overvaluation estimated at 1.6%.While
we fully recognize many stipulations behind expecting mean reversion from
REERs, we refrain from interpreting the results of our analysis as a viable
trading signal, as currencies do not always trade in line over short term
horizons due to current account trends.

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